How to be a debt detective

If you looked at a business’s balance sheet, you’d probably (and reasonably) expect to see a list of all its assets and liabilities. Sometimes you will but at other times, some of those liabilities will be hidden. In this article you’ll learn where and how to look for them.

Table 1: Eastfield balance sheet

Assets ($m)

100

Liabilities ($m)

80

Equity ($m)

20

Let’s start with a fictitious example of how debt can lurk off-balance-sheet. Eastfield is a property group whose sole asset is a $100m shopping centre. As you can see from its balance sheet in Table 1, it’s funded with $20m of equity and $80m of liabilities (debt).

A second company, Enrun, owns a 60% stake in Eastfield. How would Enrun carry its investment on its own balance sheet? There are two intuitive approaches that its accountants could follow.

Key Points

You won't always see all of a business's debt on its balance sheet

Hidden debt can be very dangerous

This article explains how you can deal with it

Table 2: Enrun balance sheet

Equity accounting

Consolidation

Assets ($m)

12

100

Liabilities ($m)

0

80

Minority interests

0

-8

Equity ($m)

12

12

The first is to use only the net value of Enrun’s investment. Eastfield as a whole is worth $20m; its equity value. Enrun owns 60% of that equity. So let’s pencil in a $12m asset on Enrun’s balance sheet.

But hold on. That doesn’t tell the full story. Enrun’s 60% stake in Eastfield represents 60% of a $100m asset and 60% of an $80m liability. Applying this reasoning, Enrun’s balance sheet would show a $100m asset offset by an $80m liability and minority interests of $8m (40% x (100m - 80m)). In other words, Enrun absorbs all of Eastfield’s assets and liabilities and backs out the minority stake that it doesn’t own in order to produce equity of $12m.

Equity accounting versus consolidation

The first approach describes ‘equity accounting’. This methodology is generally used when a business owns 50% or less of an investment and doesn’t have control over it. The second is called consolidation. It’s applied to investments which are more than 50% owned, or which are controlled in some other way.

While equity accounting is a sensible treatment for small, unleveraged investments, it’s misleading with larger and highly leveraged ones. In the example above, equity accounting makes Enrun look far better capitalised and less risky than it actually is.

That’s a big problem. When investors don’t realise they’re exposed to such debts, they can get into a lot of trouble.

Where are you most likely to find off-balance-sheet debt? The most troublesome areas are listed infrastructure stocks, property groups and financial companies.

Typically, property and infrastructure groups enter joint ventures (and use equity accounting) when they can’t afford to buy an entire asset. This means that precisely when a business is financially stretched, investors can’t see all its debt on the balance sheet.

Banks and other financial institutions, on the other hand, can use off-balance-sheet debt to achieve greater leverage without breaching capital adequacy requirements.

Crouching tiger, hidden debt

Having identified the problem and why it arises, let’s now fix it using a real life example.

Table 3: Goodman Group balance sheet

Assets

($m)

Liabilities and equity

($m)

Current assets

1,020

Current liabilities

460

Equity accounted investments

2,279

Non-current liabilities

2,416

Other non-current assets

4,299

Total liabilities

2,877

Equity

4,722

Total assets

7,598

Liabilities + Equity

7,598

Table 3 is a simplified version of Goodman Group’s balance sheet as at 30 June 2010. Like the first version of Enrun’s balance sheet, only the net value of Goodman’s equity accounted investments in associates and joint ventures are shown.

In Table 4, though, we’ve adjusted Goodman’s balance sheet by splitting the $2,279m of equity accounted investments into $5,055m of assets and $2,776m of liabilities. Acquiring those figures required hunting through Note 13 of Goodman’s accounts and finding the assets, liabilities, and proportional ownership of each of Goodman’s 34 joint ventures and associate entities. This sort of accounting detective work takes time but is very necessary.

Table 4: Goodman Group adjusted balance sheet

Assets

($m)

Liabilities and equity

($m)

Current assets

1,020

Current liabilities

460

Prop. assets of JVs and assoc's

5,055

Non-current liabilities

2,416

Other non-current assets

4,299

Prop. liabs of JVs and assoc's

2,776

Total liabilities

5,653

Equity

4,722

Total assets

10,374

Liabilities + Equity

10,374

Arcane accounting rules mean these figures are close estimates rather than exact amounts. But the big picture is clear: Goodman’s financial position is far less flattering when all its liabilities are brought on-balance-sheet. Its $4.7bn of equity actually supports $5.7bn of liabilities, double the $2.9bn that its balance sheet shows.

A serious concern

Investors can get away with not knowing most accounting intricacies but it’s crucial that you understand this one.

The fates of Babcock & Brown, Allco Finance Group and the Rubicon suite of funds explain why. All had opaque balance sheets and off-balance-sheet debts. That’s not why they went broke; any old debt would have done the trick. But it’s probably the reason that these risky and leveraged businesses reached the heights that they did, and why so many investors got wiped out as they imploded.

With off-balance-sheet debt, what you don’t know can really hurt you. But if you apply these concepts, you can avoid these painful and potentially disastrous mistakes.

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